PAPER WRAP-UP: Due Diligence Guidelines for the Review of Microcredit Loan Portfolios: A Tiered Approach, by Robert Christen

Written by Robert Peck Christen, working draft made available for field-testing, recommendations invited at r.christen@bouldermicrofinance.org, released June 2005 by the Consultative Group to Assist the Poor (CGAP), 39 pages, full-text available at: http://www.microfinancegateway.org/files/26200_file_26200.pdf

The paper presents the a due diligence tool for regulators, grantors and investors to evaluate the accuracy of a microfinance institution’s (MFI) reported portfolio quality and the extent to which it employs sound loan management practices. MFIs can be a risky investment (p2), and external audits often fail to accurately identify the primary risk facing investors – misrepresentation of portfolio quality – because they depend on the assumed veracity (p3) of an MFI’s management information system (MIS). The author states (p2) that MFIs suffer from three potentially fatal weaknesses:

– “Basic governance of MFIs is weak… Given that the profit motive is not predominant in most cases, boards of directors… may fail to act aggressively to rein in their managers.”

– “Potential exists for rapid deterioration of portfolio quality… Loan delinquency… can increase rapidly when management deteriorates.”

– “Most microloans are unsecured (they do not require collateral)… Thus, when loan portfolio quality suffers substantially, MFIs face far greater loan losses relative to the amounts outstanding than intermediaries that operate other types of portfolios secured with collateral.”

The Loan Portfolio Review Tool is a three-tier due diligence process, with each tier digging progressively deeper into an MFI’s lending policies, loan administration, and credit-risk control procedures. The tool aims to verify the following (p4-5): the accuracy of accounting and loan tracking systems; that techniques used to artificially reduce loan delinquency levels are not used; that policy exists for loan provisioning; that measures for recovering and writing off bad loans are in place; that measures are in place to prevent wholesale fraud; and that the MFI is not managing its loan portfolio in a risky manner.

Tier I (p6-18)

A Tier I review takes about two days, and is recommended for donor agencies that are considering making a small grant (p5). A Tier I due diligence consists of four steps (p6):

An analyst should gather financial information on the MFI prior to field visit (p9):
Perform a desk review (p10-11) – an evaluation of the overall financial performance of the MFI.
Make a field visit (p12) – an onsite discussion with the senior management covering the country’s economy, regulatory environment and microfinance market, and the MFI’s loan portfolio, methodology, and management.
Prepare the final analysis (p18)

A Tier I review should provide a basic level of comfort (p5) about the quality of a program’s portfolio management and performance.

Tier II (p18-26)

A Tier II evaluation begins where Tier I left off, and involves a two to five-day review (p5) by one or two analysts at the branch level. It is based primarily on qualitative research with the goal (p18) of assessing whether what was presented at the Head Office is consistent with what is happening in the field. It is recommended for those considering sizeable grants or investments in an MFI (p5).

Tier III (p26-34)

A Tier III evaluation takes two to four-weeks on-site by a team of local auditors, and another two weeks (p28) of off-site analyzing. Tier III aims to quantify asset quality through statistical sampling and analysis (p5). It is recommended when MFIs are wishing to access capital market funding mechanisms (p5). The end result (p26-27) is a quantifiable understanding of the risks to the loan portfolio and an ability to make an informed judgment as to the future of that portfolio.

Conclusion

The author states, “…The first round with any particular MFI is bound to reveal substantial difficulties in the management systems of that MFI. But the process of having the appraisal done proves to be quite instructive to MFI management…”

By Ryan Hogarth, Research Assistant

Additional Resources:

“Due Diligence Guidelines for the Review of Microcredit Loan Portfolios: A Tiered Approach” , by Robert Christen, Consultative Group to Assist the Poor: June 2005